The cash flow coverage ratio is the ratio of operating cash flow to its debt. It is used to understand whether the company is capable of paying its debts from its income from operations or not. It is useful to investors, banks, creditors, and the management of the company itself for self-evaluation.
Businesses need cash flow to cover their expenses and pay off their liabilities. Whether a big firm or an SME, cash flows are a very important aspect of every business entity. The cash flow coverage ratio is a liquidity ratio that helps to understand the position of the cash in a business and whether that is sufficient or not to pay off the debts and the expenses of the business or not.
Every business has some current liabilities which it has to meet and thus requires money which is the cash flow generated from the operations. If a company cannot pay off its current expenses and obligations, it is either not utilizing its resources fully, or there is inefficiency in the uses of the resources. Thus cash flows fall short of the obligations it has. It is a measure of liquidity of the business at current times, whether it can pay off the mandatory expenses like rent, interests, preference dividends, etc., or not.
The other two terms similar to this ratio are:
What is a Cash Flow Coverage Ratio?
This ratio can be defined as the measure or indicator of a company’s or business’s capability to fund its own current expenses. This ratio indicates whether the cash generated from the main operation of the business is enough or not to pay off its mandatory expenses (current obligations). The operating cash flow is the amount obtained by the business with its primary products or services. The simple cash flow coverage ratio analysis says that anything more than one is a good ratio, indicating that the company’s fund is more than its current liabilities. But a ratio less than one indicates that the company has fewer funds than the required sum for paying off its liabilities. It might have to consider refinancing or restructuring the operations to generate more cash flows.
Calculation and Formula of Cash Flow Coverage Ratio
The basic formula for calculation is as follows:
Cash Flow Coverage Ratio = Operating Cash Flows / Total Debts
But there are different versions of the ratio which are actually used in financial calculations to deal with different types of debts.
- Short-term Debt Coverage Ratio = Operating Cash Flows / Short-term debt
- Dividend Coverage Ratio = Operating Cash Flows / Cash Dividends
- Capital Expenditure Coverage Ratio = Operating Cash Flows / Capital Expenditures
- CAPEX+ Cash Dividends Coverage Ratio = Operating Cash flows / (Capital Expenditures + Cash Dividends)
You can also use our Cash Flow Coverage Ratio Calculator for instant calculations.
Examples of Cash Flow Coverage Ratio
Let us assume a Co. has a short-term debt of USD 100000, Cash dividends to be paid of USD 50000, Capital Expenditure of USD 500000, and the operating cash flow for the year is USD 900000.
Short-term Debt Coverage Ratio = Operating Cash Flows (OFC) / Short-term debt = 900000/100000 = 9
Dividend Coverage Ratio = OCF / Cash Dividends = 900000/50000 = 18
Capital Expenditure Coverage Ratio = OCF / Capital Expenditures = 900000/50000 = 1.8
CAPEX+ Cash Dividends coverage Ratio
= Operating Cash flows / (Capital Expenditures + Cash Dividends)
= 900000/ (500000+50000) = 900000/550000 = 1.64
Cash Flow Coverage Ratio
= Operating Cash Flows / Total Debt
= 900000/ (100000+50000+500000) = 900000/650000 =1.38
Analysis of Cash Flow Coverage Ratio
The cash flow coverage ratio analysis is the main motive behind finding these ratios. Here, in the above example, all the ratios are more than one, which depicts that the company has a good cash flow to pay its debt. But if we dig a little deeper, we would find that Johnson & Co. may be very good at paying off its short-term debts as the short-term debt ratio is 9, which means its operating cash flow is nine times more than its short-term debt amount.
But when we see the capital expenditure coverage ratio, it is only 1.8 times, but that is still fine. Then we come to this ratio which is 1.38 times which means the operating cash flow is only 1.38 times the total debt of the company. In a stable business cycle, this might not be a sign of a problem, but in case of turmoil in the business, the company can pay its short-term debt easily but might find it challenging to pay the long-term ones.
Uses of Cash Flow Coverage Ratio
The importance of this ratio is different for different people.
Management of a Company
For the internal members of the business entity like the managing director or the CEO, it is a metric to understand whether they are in a good position to pay off their liabilities or not.
For the banks which will sanction loans to the company, calculate this ratio to find out the credibility of the business entity and the risk associated with repayment.
For the investors, it is the dividend factor that plays in the mind whether they will be paid the dividend on time or not, and for the creditors, again, whether their debt will be paid off on time or not and if there is a crisis what can be the scenario.
The shareholders also calculate this ratio for cash dividend payments as they are the last on the checklist when the business liquidates. If they find that the ratio is high, then the company might also distribute more dividends to the shareholders.
When this ratio is implemented with other financial calculations, it gives insights into the company’s earnings and how the earnings are utilized, and a lot of other facts and aspects.
The cash flow coverage ratio thus helps in understanding the ability of the company to pay off its debts, whether short-term or total debt, and even the dividend payments. It gives the investors, creditors, and financial institutions insight into the company’s earnings and whether the resources are optimally utilized or not to generate operating cash flow at its best.
Visit Coverage Ratio & its Types for details about other types of coverage ratios.